Another Dividend Play for a Lifetime

A few months ago, I highlighted McDonald's (NYSE: MCD) as the dividend play for a lifetime. Since then, the stock has made a straight path upward, climbing a dividend-adjusted 9.2%, outpacing the S&P's increase of 5.8%. I highlighted the company's hidden assets, its shareholder-friendliness, and its rapid dividend increases.

I'm back today to recommend another dividend play for a lifetime. The company is Microsoft (Nasdaq: MSFT) , whose product you're probably using right now. Like McDonald's, the company is plumping its dividend at a torrid pace and has a defensible business franchise, meaning it can boost those payouts for years to come.

High growth meets high yieldMicrosoft has been an exceptional dividend star over the past few years. It has fattened its dividend on average by 15% over the past five years -- a clean double in that half-decade. That's a solid gain, but it looks like Microsoft has plenty more increases in store. While its yield stands at 2.6%, well above that of the average S&P stock, it's not the stuff of legend. But as an income investor, you need to balance high yield with high dividend growth. The growth rate is as vital as the dividend.

Microsoft and Johnson & Johnson both offer lower yields, but with their excellent consumer franchises (despite J&J's current problems) they have greater potential for high year-after-year increases. In fact, as Microsoft's growth slows from the torrid pace of yesteryear and it increasingly offers a substantial payout, the company is reorienting itself as a more shareholder-friendly organization.

Contrast their payouts with those of Frontier and Annaly. The latter offer sizable dividends now, but the prospect for future increases is much dimmer. Frontier has done a good job under CEO Mary Wilderotter of milking profit from a declining fixed-line telecom business. The company recently ratcheted back its payout as it beefs up operations recently purchased from Verizon.

Annaly has been pumping out mighty dividends over the last couple of years. As interest rates plummeted, Annaly's net interest margin fattened, as did its payouts. Annaly could be a great play as long as low inflation remains, but the company is monitoring interest rates closely. If and when rates increase -- more likely, skyrocket -- the company could see a disruption in those payouts.

Now, I'm not criticizing investors in those companies. Heck, I'm an investor in Frontier and Annaly, because I still see legs in the investments. Frontier still looks undervalued to me, and I think deflation or at least very low inflation, will be with us for quite a while, so Annaly's gaudy payouts should continue in the meantime. But I do like to mix high yields with high growth to obtain a better blended payout. I also own shares of Microsoft, having upped my position recently, as I promised when I pitched it as a Motley Fool "11 O'Clock Stock" recently.

Microsoft for lifeMicrosoft has given every indication that it intends to pay out a substantial portion of its free cash flow. Over the last decade Mr. Softy has returned $170 billion in dividends and repurchases and it still has $24 billion remaining on a repurchase authorization. Over the last four quarters, the company has doled out $4.5 billion in dividends and it just recently boosted its dividend by 23%, so you can bet more will be coming your way. Microsoft is methodically transforming itself into a dividend dynamo.

Even better, the stock itself is cheap. It trades at just 12 times trailing earnings. Back out its massive net cash hoard of $30 billion, and you're looking at a business trading at just 10 times trailing earnings. Using Ben Graham's growth formula, Microsoft's price implies earnings growth of less than 1%. But the company has done much, much better than that over the last five years: Earnings per share have climbed 13.3% annually on average. That pales compared to annual EPS growth at rival Apple (Nasdaq: AAPL) , of course, at 62%, but you do have to pay a higher multiple for Apple. And Microsoft has few expectations baked into its prices, meaning little downside risk. In this environment, that's key.

Microsoft has very defensible businesses in its Windows and Office segments, and it has the ability to successfully defend them without major difficulty. Both of these segments have at least 90% share, and each generated about $12 billion in operating profit last year. Its Server division added another $5 billion. Despite low-return efforts in mobile software, search, and music, Microsoft still has tremendously dominant, tremendously profitable franchises.

And it's working hard to promote their dominance as we move into the cloud-computing arena. With a comprehensive set of software solutions, the company can offer discounts to businesses for going all-Microsoft. In addition, it's been working to tie its software into a seamless set of solutions. So the software giant is taking many good steps to lock in and even strengthen its monopolistic position.

Contrast that competitive position with that at Altria (NYSE: MO) , where the company is hounded by government regulators, higher taxes, and waning smoking rates. It is besieged from every direction, but the company has committed to paying out 80% of its profit as dividends, so it now sports an eye-bulging 6.2% yield. That's great for current yield, but it's easy to imagine scenarios in which Big Tobacco's significance wanes over the next couple of decades, or sooner.

So it could make a lot of sense to match up Microsoft's lower current yield and brisk growth rate with Altria's higher yield but cloudy future. That's one way to go, in any case.

Foolish bottom lineA tech titan. A cheap price. A larded-up and growing dividend. I might just add more Microsoft shares to my portfolio. How 'bout you? Let me know what you think in the comments box below.

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I like your analysis of the situation. Microsoft has disappointed for years but if they keep increasing their dividends transforming itself it is a great stock for the future. Frontier on the other hand is in a dying business, earnings can't substain is dividend payout.....I foresee a dividend cuts....Frontier thanks for the returns but I think I will move on before the dread axe falls.

Not a big fan of MSFT; prefer AAPL. Maybe own a little of both. But definitely write calls against MSFT to increase yield. With the stock at 25.54 you can write a Nov 26 and get 53 cents of premium (plus the 16 cent div that goes ex on Nov 16, before option expiration). Earnings come out Oct 28.

Jim, You wrote a very thought-provoking article. I don't know much about Tech, so I stay away from most of it. I do like Automatic Data Processing. This is a Powerhouse Company which has a nice Yield and has been buying firms to help its business grow. ADP's share count is also positive for potential profits, especially when it is compared to Microsoft's, and ADP is teaming with IBM in the Cloud-Computing Space. Interest Rates will not skyrocket very soon with the struggling U.S. Economy, as Lenders cannot afford to raise them, fearing very few folks will buy High-Ticket items, so Annaly Capital should do well for Long-Term Investors, and people will not stop drinking or smoking, making Altria another fine choice.

@backness: I'm an IT guy and there's a huge misunderstanding about virtualization.

Going to "the cloud" means moving your installation of MS Server from separate machines to one, either on your local network or offsite, It doesn't affect the number or cost of server software licenses you'll need. If you subcontract your domain or mail services to a company running VMWare, you'll still need to buy or lease a license of MS Server or Exchange. If a virtualization company wants to offer domain and mail on a per client or domain cost basis, they'll have to buy an Enterprise copy of MS Server or Exchange and pass on those costs to the customers. But either way, if you want to use MS-based domain or email, Microsoft is going to get paid.

Virtualization is going to have a big impact on IT hardware, particularly server hardware. The days of Dell and HP selling a $2500 stand-alone box to small businesses are coming to an end, but the businesses that used Microsoft before are still going to be paying for MS licenses from their cloud providers.

Look, I love dividends. But mcdonalds (MCD) is currently at 3.15% which is pretty low. Let's compare to at&t (T) at 5.93%. My calculation shows MCD dividends rising at 14.5%/year the last three years. T dividends rose 6.21%/year the last four years. I took the trouble of entering this into a spreadsheet;

mcd t

year 1 $ 3.15 $ 5.93

year 2 $ 3.61 $ 6.30

year 3 $ 4.13 $ 6.69

year 4 $ 4.73 $ 7.10

year 5 $ 5.41 $ 7.55

year 6 $ 6.20 $ 8.01

year 7 $ 7.10 $ 8.51

year 8 $ 8.13 $ 9.04

year 9 $ 9.31 $ 9.60

year 10 $ 10.66 $ 10.20

year 11 $ 12.20 $ 10.83

year 12 $ 13.97 $ 11.50

year 13 $ 15.99 $ 12.22

year 14 $ 18.31 $ 12.98

year 15 $ 20.97 $ 13.78

total $ 143.86 $ 140.25

As you can see, even though MCD is gaining, it does not catch up until the fifteenth year.

This does not account for the time-value of money where (T) is paying a lot more the first nine years: money that can be reinvested in other worthy companies. Sorry, 3.15% might barely cover taxes and inflation...not my kind of investment.

IMO, Altria's vs. Microsoft is a wash. As noted, with cloud computing beginning to take off, especially with the google's and amazon's, Microsoft no longer has the competitive edge in software management. They're still the leader but they're not longer the de facto monopoly they once were. No doubt they'll gain revenue from other areas (Windows 7 mobile for example) but how much they'll gain is just a speculative play at this point.

Now if Altria were just a smoking company, I'd agree with all you said but some of those concerns are already built into the valuation of the stock. They also have a 29% ownership stake in SAB Miller - the 2nd largest brewer in the world. In addition, Altria has a history of being very generous to its shareholders (spinning off shares in Kraft and PMI directly to shareholders), irregardless of the dividend.

Altria's clearly had a better run this year than MSFT. Do you go on valuation believing MSFT to be undervalued relative to the market (it's off nearly $6 from it's years high with a PE of 12-ish) or do you go with the winner with a big fat dividend?

I don't see Microsoft leading innovation anymore nor is its moat as impregnable as everyone used to think. The truth is that they have been lacking in development for the past decade. Too much of a reliance on past success & reputation. I think this dividend business is just a woo tactic to snatch up investors and sweep up poor development under the rug. Time to come up with new methodologies instead of building a giant house of cards on 30yr old programming. Another cause for concern is that over 40% of the operating margin comes from Office. Yes, Office will be around for a long time and people will always use it, but there are actually strong competitors emerging here which means eventually profit margins must drop as the price comes down. Look at the last ditch price drop during negotiations to prevent P&G moving to Google Apps. That was just a sign of things to come.

I am so confused about statements made against MSFT. They are incredibly strong in their positions. They still innovate and ill explain. 30 year old programming? they are already working on a 128 bit OS, and have already removed DOS4gw for the backbone of the kernel. now you have your old programs and games that don't work anymore... they are moving forward, and they are leading the way. APPL has leaps and bounds to go before they innovate anything other than iOS. The ipad is a useless giant iphone that doesn't make phone calls, but still uses 3G, amazing flop. its too big in size, and too little in hardware, it will be replaced. ALSO lets not forget that it was bill gates that said someday you will have a computer that will fit in the palm of your hand...

I also want to point out that they have moved into another industry and they are there to stay. GAMING!!! this industry is the 2nd largest form of media entertainment in the world (next to porn). It has the the best dollar cost average of entertainment value. meaning i can get 100 hours of entertainment for $10-$50 depending on the game. that translates in pennies on the dollar when you think of going to the movies. you and your date go, $10 each, so that's $20 for a 1.5-2 hour movie.... bad dollar cost average. MSFT has penetrated the industry, pinned Nintendo into a corner with a whole different niche (being young kids and family games) and is beating Sony Computer Entertainment group's PlayStation 3 in sales. Not to mention they just came out with they Kinect which beats the pants off off SONY's GO or MOVE wand controller, and not to mention Nintendo's Wii as well. They built it from the ground up and its a whole different level of human interface, and it will change the game industry, and they have all the rights to it.

This is all completely separate from the obvious fact they they still make 90% of the worlds computers Operating Systems, still own even the other 10%'s back end systems. and licensing software they don't even have to put on disc is the epitome of the CLOUD. Open Source will not take down anyone. Open source is a beautiful thing, but almost every time it becomes something tangible someone buys it and figures out how to make money off it. Look at Linux. its an open source operating system, but when you think of Linux, you think of RedHat or one of the other "distributors" that has figured out how to make money off it, and has killed its growth.

I can go on and on. but the point is that MSFT isn't going anywhere and Oracle isn't going to buy them out anytime soon, and if they do, good on them, i will just have consolidated my shares then. All that will mean is i need to re-diversify.

P.S. just because your reading this from a mac, doesn't mean MSFT doesn't still rule the world of computing. I bet your exchange server where you get you mail still has a MSFT license on it right? oh yeah and I'm sure your still using MS Office 2007 right? you just dropped an operating system and you use safari to browse the web, but for you to read this article, MSFT software has touched this page 10 ways to Sunday and back again just to deliver it to your computer screen.

One of the best articles in a long time. Thank you! As far as Altria goes I feel like they will continue to prosper regardless of tax increases, regulations, warnings to stop smoking, etc. My reasoning is very simple. Heroin and crack dealers contnue to make a fortune simply because they sell an addictive substance. Do you see crack heads stopping because of price increases or jail time - NO WAY! Addicts don't give a hoot and nicotine is one hell of an addictive substance. I own PM and love that company. I chose PM over MO simply because they are facing a bit less problems overseas. With MO my only worry is a major lawsuit loss but I still think they can take that punch and recover due to the addictive substance angle. If there were a company that was allowed to sell crack I may dislike the principal but not the money it would generate - just to make a point! I own MSFT and although it's flat and pays a low dividend by my standard it is such a solid company that cloud computing will not blow them away in my lifetime so I don't worry about that. I am actually thinking of selling MSFT because I'm very close to retirement and I don't see it producing any big money for me. Anyway, I thank you again for a very well written analysis of the companies mentioned. You are right on!

"The company is Microsoft (Nasdaq: MSFT), whose product you're probably using right now"

Nope, I use Linux and have since 1998. It is free (as in cost and is open source ), including most applications . What this means is I actually OWN the software instead of just renting it from MS. Additionally, when you install MS's OS, such as Win7, you get virtually no applications, you must pay additional sums if you wish you gain any functionality.

I am not knocking MS's monetization schemes. That is what has made them the power that they are.

Given that Microsoft's stock has been stuck in the 20's with an occasional run up to the mid 30's for 5+ years, and the continuous run of product introduction flops (always trying to catch up to the real innovators), I can't possible see why one would invest in them. I see writers & pundits plugging the stock continuously in recent months and wonder what their real motivation is. I no longer use Internet Explorer or Microsoft Office and never will again. One is balky and unreliable & the other is ridiculously overpriced. They've been replaced by Open Office and Google Chrome on all our computers. Microsoft's stranglehold on computing is slowly being replaced with many different and varied options & I tend to agree with those who say they will eventually be irrelevant.